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As Equities Surge, Corporate Pensions Approach Fully Funded Status

Defined benefit plans are finally climbing out of the hole. Now their sponsors face a new set of issues, like whether to retain a plan or not.

If you are a corporate pension plan sponsor, the good news is in: 2014 looks likely to be the year defined benefit plans attain fully funded status, that is, with 100 percent of the assets available to match future liabilities. In fact, says Karin Franceries, executive director of the U.S. strategy group at J.P. Morgan Asset Management, one pension fund in four is now overfunded.

That is also good news for shareholders of Russell 3000 companies that provide defined benefit plans for their employees. “This is the first time in six years that shareholder equity has increased, thanks to pensions, and debt is reduced, thanks to pensions,” says Franceries. The increase in equity and the reduction in debt each amounted to about 7 percent, while the funding status should have reached 96 percent by December 31, according to J.P. Morgan.

There are two reasons for this funding improvement. First, investment gains have improved to 10.38 percent in 2013 through November 30, as measured by New York–based investment consultant Milliman. Second, the discount rate by which future pension payouts are calculated has grown to 4.78 percent, up from 3.96 percent on December 31, 2012. This higher number represents a decrease in the discounted value of the liabilities.

The funded status of the 100 largest pension plans improved by $34 billion in November alone, reducing the deficit to $93 billion, as measured by the Milliman 100 Pension Funding Index. In the aggregate, Milliman’s 100 plans come close to a 94 percent funding ratio.

The last time corporate pension sponsors enjoyed such a happy New Year was 2007. Lacking a crystal ball, corporations for the most part made no special effort to maintain pension surpluses, even as they stood on the edge of crisis and recession. This time will be different, argues Franceries, as sponsors look to take advantage of their recent good fortune and lessons learned from the financial crisis. They have several choices to consider, depending on their circumstances.

A common theme across all pension funds is that sponsors want to protect their fully funded status or their surpluses. One way to do that is to invest more assets in fixed income, despite the current low, if rising, returns. “Why would you want to run a risk in your portfolio if you’re overfunded?” asks Franceries.

It’s not quite so simple, however. There are three reasons growth assets such as equities remain essential to pension health: longevity risk, credit risk and service costs. The impact of retirees’ increased longevity can have a 3 percent to 5 percent negative effect on plan liabilities, says Franceries. Then there is the credit component of the discount rate, which is calculated using the yield on AA corporate bonds. This is not a risk-free rate and is thus subject to default and downgrade risk. Lastly, since the average service cost for plans is 1.8 percent of liabilities, one without contributions would need a 6.9 percent return to retain its 100 percent–funded status over ten years, notes Franceries. You’ll probably need some equity component to get that return.

As a result of the financial crisis, many plan sponsors in the Milliman 100 have turned to derisking procedures, says Zorast Wadia, a Milliman consultant. Perhaps the most notable has been record-setting annuities for retirees purchased by Verizon Communications, General Motors Co. and Ford Motor Co. in 2012, transferring the risk to an insurer. (Beneficiaries received either annuity payments or a lump sum.) The annuity trend faded in 2013, probably because sponsors began locking in their improving funded status using so-called liability-driven investing with higher fixed-income allocations. The aim of LDI is not to beat a benchmark but to prudently meet known future liabilities.

The expense of purchasing an annuity from an insurance company to substitute for a pension may prove be too steep for many companies. But with pension funds approaching or reaching 110 percent funded, sponsors can take steps to lock that in, showing lifetime pension income on its financial statements instead of pension expenses, says Zorast. “It may be cheaper to keep her,” meaning the pension plan, he quips. “Now you’re turning back to the 1980s and ’90s,” which also saw overfunding.

David Zion, an equity analyst at New York–based ISI Group who heads the firm’s accounting and tax research team and who follows pension funding closely, observes that with few exceptions, notably United Technologies Corp., the current funding improvement has not yet become part of companies’ earning guidance or analysts’ earning estimates. He also cautions that improvements have not appeared across the board. Plan sponsors who bet heavily on long-duration fixed income in 2013 missed out on the surge in equity returns and interest rates. “I’ve been reminding investors of that,” says Zion, who recently moved to ISI from Credit Suisse.

To further quell the excitement of those cheering on an impending pension fund bonanza, Zion points to the numerous ways pension obligations are measured. Depending on the method, some plans may not be fully funded on a termination basis derived from, for example, generally accepted accounting principles, a close-out annuity basis or the use of the Pension Benefit Guaranty Corp.’s calculations.

When it comes to the future , Zion expects to see more plans frozen and more companies looking to get out of the defined benefit pension business entirely: through annuity contracts, lump sum settlements or derisking a plan through liability-driven investing.

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